Monthly Archives: February 2020
In December 2019, the SEC proposed rules that would require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals. The proposed rules have an interesting history. In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court. In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress. However, the statutory mandate in the Dodd-Frank Act requiring the SEC to adopt these rules requiring the disclosure remains in place and as such, the SEC is now taking its third pass at it.
The proposed rules would require domestic and foreign resource extraction companies to file a Form SD on an annual basis that includes information about payments related to the commercial development of oil, natural gas, or minerals that are made to a foreign government or the U.S. federal government.
The Dodd-Frank Act added Section 13(q) to the Securities Exchange Act of 1934 (“Exchange Act”) directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.
As noted above, the first two passes at the rules by the SEC were rejected. The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects. In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors. The rules were also thought to exceed the SEC authority.
The proposed rules make many significant changes to the rejected 2016 rules. In particular, the proposed rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) review the definition of “not de minimis” at both the project and individual payment threshold such that disclosure of a payment that equals or exceeds $150,000 would be required when the total project payments equal or exceed $750,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made at a level below the major subnational government level; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.
The proposed rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q). Under the proposed rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F. Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered. Moreover, smaller reporting companies and emerging growth companies are exempted.
The proposed rules would define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity. The proposed definition of “commercial development” would capture only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The proposed definition of “commercial development” would capture only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.
Likewise, the definitions of “extraction” and “processing” are narrowly defined and would not include downstream activities such as refining or smelting. “Export” would be defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource. Companies that provide transportation services, without an ownership interest in the resource, would not be covered.
Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits. The proposed rules would define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure. Furthermore, an anti-evasion provision will be included such that the rules would require disclosure with respect to an activity or payment that, although not within the categories included in the proposed rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).
A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place. As proposed, a resource extraction issuer would have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral. The disclosure would be at the broad level without the need to drill down further on the type of resource. The second prong would require a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining. Again, additional details would not be required. The third prong would require an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.
Under the proposed rules, a “foreign government” would be defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” would include a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government. On the other hand, “federal government” refers to the government of the U.S. and would not include subnational governments such as states or municipalities.
The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate. Under the proposed rules, Form SD would expressly state that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited. The report will cover the company’s fiscal year and will need to be filed no later than nine months following the fiscal year-end. The Form SD must include XBRL tagging.
As noted above, the proposed rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts. In addition, the rules contain a targeted exemption for payment related to exploratory activities. Under this proposed targeted exemption, companies would not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year. The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.
Finally, the proposed rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO. When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year. Similarly, companies that complete an IPO would not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.
In December 2019 the OTC Markets updated its Pink Disclosure Guidelines and Attorney Letter Agreement and Guidelines. The Pink disclosure guidelines and attorney letter apply to companies that elect to report directly to OTC Markets pursuant to its Alternative Reporting Standard. Furthermore, in January 2020 OTC Markets amended the OTCQB standards related to the disclosure of convertible debt and notification procedures for companies undergoing a change in control. The OTCQB also updated its criteria for determining independence of directors, and added additional transfer agent requirements for Canadian Companies.
The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. Companies trading on the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets have the option of reporting directly to OTC Markets under its Alternative Reporting Standards. The Alternative Reporting Standards are somewhat more robust for the OTCQB and OTCQX in that they require audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor in the same format as would be included in SEC registration statements and reports.
As an aside, companies that report to the SEC under Regulation A and foreign companies that qualify for the SEC reporting exemption under Exchange Act Rule 12g3-2(b) may also qualify for the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets if they otherwise meet the listing qualifications. For more information on OTCQB and OTCQX listing requirements, see HERE and HERE.
Effective February 22, 2020, the OTCQB Standards, Version 8, will go into effect. Some of the rule changes were previously adopted and others have been added to or modified. In particular, the new Version 8 includes:
Debt Securities, Including Promissory and Convertible Notes – Companies will be required to provide prompt disclosure of the issuance of any promissory notes, convertible notes, convertible debentures, or any other debt instruments that may be converted into a class of the company’s equity securities. Such disclosure must include copies of the securities purchase agreement(s) or similar agreement(s) setting forth the terms of such arrangement, any related promissory notes or similar evidence of indebtedness, and any irrevocable transfer agent instructions. Companies must make such disclosure either through the SEC’s EDGAR system or the OTC Disclosure & News Service, as applicable. Effective December 12, 2019, OTC Markets made a similar rule change for OTCQX listed companies.
OTCQB Certifications – Companies will be required to list and describe any outstanding promissory notes, convertible notes, convertible debentures, or any other debt instruments that may be converted into a class of the issuer’s equity securities when completing OTCQB certifications. OTC Market has been vocal about concerns with convertible instruments and, in particular, the potential for extreme dilution to existing shareholders and stock promotion campaigns by certain convertible investors. For more on OTC Markets stock promotion guidelines and policies, see HERE. As I have written about many times, there are quality investors and others that are not quality in the micro-cap space. The use of convertible instruments as a method to invest in public companies is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. The requirement to disclose these investments, and the investment documents, is a smart change for OTC Markets, adding a level of transparency to the marketplace as a whole.
Change of Control – The new rule release reiterates the requirements related to a change of control. In particular, effective July 31, 2017, OTC Markets amended the OTCQB rules to set standards related to the processing and reporting of change in control events (see HERE). Subsequently, effective April 16, 2019, OTC Markets updated the definition of a “change of control” to include any events resulting in:
(i) Any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) becoming the “beneficial owner” (as defined in Rule 13d-3 of the Exchange Act), directly or indirectly, of securities of the company representing fifty percent (50%) or more of the total voting power represented by the company’s then outstanding voting securities;
(ii) The consummation of the sale or disposition by the company of all or substantially all of the company’s assets;
(iii) A change in the composition of the board occurring within a two (2)-year period, as a result of which fewer than a majority of the directors are directors immediately prior to such change; or
(iv) The consummation of a merger or consolidation of the company with any other corporation, other than a merger or consolidation which would result in the voting securities of the company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity or its parent) at least fifty percent (50%) of the total voting power represented by the voting securities of the company or such surviving entity or its parent outstanding immediately after such merger or consolidation.
Under the change of control rule, a company is responsible for notifying OTC Markets upon the completion of a transaction resulting in a change of control and must submit a new OTCQB application and application fee ($2,500) within 20 calendar days. OTC Markets will review the notice and application and may request additional information. The failure to respond or fully comply with such requests may result in removal from the OTCQB. Furthermore, immediately following a change in control event, a company is required to file a new OTCQB certification and updated company profile page. Regardless of notification, OTC Markets may also make a discretionary determination that a change of control event has occurred.
The newest rule release clarifies that the failure to submit the new application and documentation within the 20 days is grounds for the suspension or removal from the OTCQB at OTC Markets’ sole and absolute discretion.
Independent Directors – The new rules amend the definition of an independent director to conform to the earlier amendment in the OTCQX rules. The definition of an independent director has been updated to mean “a person other than an executive officer or employee of the company or any other person having a relationship which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent: (A) a director who is, or at any time during the past three years was, employed by the company; (B) a director who accepted or has a family member who accepted any compensation from the company in excess of $120,000 during any fiscal year within the three years preceding the determination of independence, other than compensation for board or board committee service; compensation paid to a family member who is an employee (other than an executive officer) of the company; or benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (C) a director who is the family member of a person who is, or at any time during the past three years was, employed by the company as an executive officer.”
Canadian Companies – Canadian companies must retain a transfer agent that participates in the Transfer Agent Verified Shares Program as of April 1, 2020 (rule change was adopted December 12, 2019).
Pink Disclosure Guidelines Amendments
OTC Markets updated the Pink Disclosure Guidelines in anticipation of changes to the SEC’s Rule 15c2-11 (see HERE). The Pink Disclosure Guidelines are designed to track the information requirements in Rule 15c2-11. The amended rules have updated the Pink Disclosure Guidelines to require:
(i) Corporate History – the name of the company and predecessors since inception (previously a company only had to provide prior names for the last five years);
(ii) Debt Securities, Including Promissory and Convertible Notes – a company must now disclose all outstanding convertible, promissory or similar debt instruments as of the period end date of the report (previously only had to disclose such obligations issued in the previous two fiscal years);
(iii) Financial Statements – must now include a statement of changes in shareholders’ equity. In addition, all financial statements for a particular period must be uploaded in one document.
(iv) Officers, Directors, and Control Persons – the rules have been amended to clarify that all 5%-or-greater shareholders of any class of outstanding securities must be disclosed; and
(v) Verified Profile – a company must verify the company profile through OTCIQ to qualify for Pink Current or Limited Information.
Attorney letters are required for a company to qualify for OTC Pink Current Information if that company does not submit audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor. In order to submit an attorney letter on behalf of a company, the attorney must submit an Attorney Letter Agreement to OTC Markets and be approved by OTC Markets. The rules related to an attorney letter agreement have been updated to allow for submittal of the agreement through Docusign.
Furthermore, the attorney letter agreement has updated required disclosures that must be included in a company’s attorney letter related to regulatory proceedings. In particular, an attorney letter submitted on behalf of a company must state that the attorney is permitted to practice before the SEC (i.e., has not been prohibited from such practice) and whether the attorney is currently or has in the past five years been the subject of any investigation, hearing or proceeding by the SEC, CFTC, FINRA or any federal, state or foreign regulatory agency, including a description of any investigation, hearing or proceeding.
Continuing its disclosure effectiveness initiative, on January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information. Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles based approach to disclosure requirements. In addition, the proposed rule changes are intended to reduce repetition and disclosure of information that is not material.
On the same day the SEC issued an Interpretive Release on MD&A. A week earlier the SEC issued three new compliance and disclosure interpretations on the subject.
Among the proposed changes, the new rule would add a new Item 303(a) to state the principal objectives of MD&A, replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements, add a requirement to discuss critical accounting estimates and add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter. On the same day as the proposed rule release, the SEC issued guidance on the disclosure of key performance metrics in MD&A.
SEC Chairs Jay Clayton and Commissioners Allison Herren Lee and Hester Peirce issued statements on the changes. Allison Herren Lee again expressed her disappointment that the SEC is not requiring additional environment- and climate-related disclosures. Chair Clayton touched on the subject, noting that the issues are complex, changing and multi-national and investor and company capital allocation decisions that are influenced by climate and environmental factors are forward-looking and likewise complex. Furthermore, disclosure requirements are generally historical in nature with limited forward-looking statement requirements, for the obvious reason that the future is impossible to predict. With that said, all companies are required to disclose material risks, expenditures and factors that affect their business, including climate change and environmental issues where relevant.
Climate and environmental disclosures are an evolving topic. The SEC continues to review and study the issue but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics. It is this exact concern Commissioner Hester Peirce spoke about in her statement noting, “[T]hanks in part to an elite crowd pledging loudly to spend virtuously other people’s money, the concept of materiality is at risk of degradation.” With that said, Commissioner Peirce supports the proposed rule changes as written, and is pleased they do not go further into environmental, social and governance (ESG) matters. For more on ESG in general, see HERE.
Proposed New Rules
The proposed new rules would completely eliminate Item 301 – Selected Financial Data; Item 302 – Supplementary Financial Information; and Item 303(a)(5) requiring tabular disclosure of contractual obligations. The proposed rules will also (i) add a new Item 303(a) to state the principal objectives of MD&A; (ii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (vi) add a requirement to discuss critical accounting estimates, and (vii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new rules also apply to foreign private issuers (FPIs). Finally, the proposed amendments would make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.
Elimination of Item 301 – Selected Financial Data
Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years. Smaller reporting companies (SRCs) are not required to provide this information and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.
When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL. Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends. Accordingly, Item 301 is not useful and the SEC proposed to eliminate it.
Elimination of Item 302 – Supplementary Financial Information
Item 302 requires selected disclosures of quarterly results and variances in operating results. SRCs and FPIs are not required to provide the information (note FPIs are not required to report quarterly results or file quarterly reports at all). Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).
In addition to the same reasons for eliminating Item 301, including duplication, the SEC has been considering the costs and benefits of requiring quarterly financial information at all.
Elimination of Item 303(a)(5) – Contractual Obligations Table
Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format. There is no materiality threshold for the disclosure. The SEC proposes to eliminate the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy.
Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
Currently MD&A is broken down into 4 parts. Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations. Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information. Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures. Item 303(d) provides scaled back disclosure accommodations for SRCs. The proposed rules would substantially change this structure.
The new Item 303 will (i) add a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods; (ii) eliminate unnecessary cross-references, clarify and remove outdated and duplicative language; (iii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) update the results of operations disclosure to require a discussion of the reasons underlying material changes in nets sales or revenues; (vi) eliminate the requirement to discuss the impact of inflation; (vii) replace the specific requirement to disclose off balance sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) add a requirement to discuss critical accounting estimates, and (ix) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new Item 303(a) instruction paragraph will be revised to set forth the principal objectives of MD&A. The instructions will codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.” Also, the instructions will emphasize providing disclosure on:
(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;
(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and
(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.
On January 30, 2020, the SEC issued an interpretive release providing guidance on key performance indicators and metrics in MD&A. Current Item 303(a) requires disclosure of information not specifically referenced in the item that the company believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations. The item also requires discussion and analysis of other statistical data that, in the company’s judgment, enhances a reader’s understanding of MD&A.
Keeping in line with the SEC’s efforts to streamline disclosures to those that are specifically material to each company, the SEC has stated that companies should identify and address those key variables and other qualitative and quantitative factors that are peculiar to and necessary for an understanding and evaluation of the individual company. The interpretive guidance reminds companies to consider whether the information they are disclosing is GAAP or non-GAAP (and thus requires compliance with Regulation G or Item 10 of Regulation S-K – see HERE).
In addition, the company should consider what additional information may be necessary to provide adequate context for an investor to understand the metric presented. The SEC expects that the following information will be provided regarding a metric: (i) a clear definition of the metric and how it was calculated; (ii) a statement indicating the reasons why the metric provides useful information to investors; and (iii) a statement indicating how management uses the metric in managing or monitoring the business. Changes in the method of calculating the metric from one year to another must also be disclosed including the reasons for and impact of the change.
On January 24, 2020, the SEC issued three new C&DI on MD&A disclosures. The new C&DI clarifies the ability to incorporate prior financial years’ MD&A by reference from a previous SEC filing. In particular, the instructions to Item 303 allow a company to incorporate an MD&A discussion from a prior report for financial statements that are more than two years old. The C&DI clarifies that to properly incorporate by reference specific language must be provided together with a hyperlink to the incorporated information. For more on incorporation by reference, see HERE.
Furthermore, if incorporation by reference is not used for discussion of a third year of financial statements, the company must assess whether the discussion is relevant and necessary for a proper disclosure of its financial condition. No discussion can be omitted that is material to an understanding of results of operations.
The third new C&DI illustrates how incorporation by reference can be used in a Section 10(a)(3) prospectus update to a registration statement that allows forward incorporation by reference. In particular, if a year of MD&A is omitted from a Form 10-K, that year will not be deemed included in the updated registration statement unless it is specifically incorporated by reference from a prior year’s filing.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
On August 8, 2019, the SEC proposed changes to disclosures related to business descriptions, legal proceedings and risk factors under Regulation S-K. See my blog HERE.
In May 2019 the SEC proposed amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. This was a follow-on to the September 2015 request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates listed further below.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE, and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018 the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Taking into account responses to portions of that request for comment, in the summer of 2018, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
In early December 2015, the FAST Act was passed into law. The FAST Act required the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.
The Nasdaq Stock Market currently has three tiers of listed companies: (1) The Nasdaq Global Select Market, (2) The Nasdaq Global Market, and (3) The Nasdaq Capital Market. Each tier has increasingly higher listing standards, with the Nasdaq Global Select Market having the highest initial listing standards and the Nasdaq Capital Markets being the entry-level tier for most micro- and small-cap issuers. For a review of the Nasdaq Capital Market listing requirements, see HERE as supplemented and amended HERE.
On December 3, 2019, the SEC approved amendments to the Nasdaq rules related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market. As previously reported, on February 15, 2019, Nasdaq amended its direct listing process rules for listing on the Market Global Select Market (see HERE).
Interestingly, around the same time as the approval of the Nasdaq rule changes, the SEC rejected amendments proposed by the NYSE big board which would have allowed a company to issue new shares and directly raise capital in conjunction with a direct listing process. In other words, the NYSE proposed an IPO without an underwriter. Although it was not clear as to all of the aspects of the proposal that prompted the rejection, in late December the NYSE made some adjustments to the proposed rule change and resubmitted it to the SEC. The most significant adjustment would be to allow listings with a capital raise of $100 million, down from $250 million in the first proposal. To qualify for the direct listing, the total value of shares, including those previously outstanding and those sold in the direct listing process, would need to be $250 million or higher. As of the date of this blog, no SEC action has been taken on the latest proposal.
Direct Listings in General
In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A company would also not necessarily need a banker in the resale direct listing process. A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC. For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.
Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering. One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees. For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.
The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Oftentimes a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.
Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering. For more on Rule 506, see HERE.
Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk. For more on the accredited investor definition including the SEC’s recent proposed amendments, see HERE.
The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.
Like many tech companies, Spotify’s share price has been erratic, but as of the date of this blog is slightly higher than its initial listing price on the NYSE. However, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option. An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.
A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).
Direct Listing on NASDAQ
A company seeking to list securities on Nasdaq must meet minimum listing requirements, including specified financial, liquidity and corporate governance criteria. Nasdaq listing Rules IM-5405-1 and IM-5505-1 set forth the direct listing requirements for the Nasdaq’s Global Market and Capital Market respectively. The Rules describe how the Exchange will calculate compliance with the initial listing standards related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
Like it previously did for the Global Select Market, Nasdaq is now providing a methodology for companies which have not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing and which wish to list their securities to allow existing shareholders to sell their shares.
Direct Listings are subject to all initial listing requirements applicable to equity securities and, subject to applicable exemptions, the corporate governance requirements set forth in the Rule 5600 Series. In addition to setting forth the method for determining initial listing requirements based on the price of a security, including the bid price, market capitalization and market value of publicly held shares, the new rules require that a listing can only be completed upon effectiveness of a registration statement that solely registers securities for resale by existing shareholders (i.e., no new shares may be registered).
The rule changes will also clarify that an IPO Cross can be used for the initial pricing of such securities. An IPO Cross is a methodology for the initiation of trading of a security where there has been no underlying IPO. To allow for the IPO cross initial trading, a broker-dealer must serve in the role of financial advisor to perform the functions that an underwriter would perform in an IPO to initiate trading.
Under the amended rules, Nasdaq will determine a security’s price based on (i) a third party tender offer for cash; (ii) a sale between unaffiliated third parties; (iii) equity sales by the company; (iv) an independent valuation meeting specific standards; or (v) a valuation as determined by a private placement market. Both IM 54-5-1 and IM-5505-1 are identical on their substantive provisions for direct listing valuations. In order to be considered evidence of valuation under (i) – (iii), the transactions must be completed within the prior six months and be substantial in size representing sales of at least 20% of the market value of unrestricted publicly held shares requirement.
In addition, any affiliate involvement in the transactions must be less than 5% per affiliate or 10% total, must have been suggested or required by a non-affiliate, and the affiliate must not have participated in negotiations.
Any valuation used for this purpose must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. The valuation must be of a recent date as of the time of the approval of the company for listing and the evaluator must have considered, among other factors, the annual financial statements required to be included in the registration statement, along with financial statements for any completed fiscal quarters subsequent to the end of the last year of audited financials included in the registration statement. Nasdaq will consider any market factors or factors particular to the listing applicant that would cause concern that the value of the company had diminished since the date of the valuation and will continue to monitor the company and the appropriateness of relying on the valuation up to the time of listing. Nasdaq may withdraw its approval of the listing at any time prior to the listing date if it believes that the valuation no longer accurately reflects the company’s likely market value.
(f) A valuation agent shall not be considered independent if:
(1) At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days.
(2) The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, “investment banking services” includes, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, Popes (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting.
(3) The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.
For a security that has had sustained recent trading in a private placement market prior to listing, Nasdaq will determine a company’s price, market value of listed securities and market value of unrestricted publicly held shares based on the lesser of: (i) the value calculable based on the valuation calculated in accordance with the standards listed above and (ii) the value calculable based on the most recent trading price in a private placement market.
For purposes of the rule, a private placement market is one that is operated by a national securities exchange or a registered broker-dealer. Nasdaq will examine the trading price trends for the stock in the private placement market over a period of several months prior to listing and will only rely on a private placement market price if it is consistent with a sustained history over that several-month period evidencing a market value in excess of Nasdaq’s market value requirement.
For a security that has not had sustained recent trading in a private placement market for a period of several months prior to listing, Nasdaq will determine that such company has met the market value of publicly held shares requirement if the company has a valuation, as calculated via the above methods, in excess of 200% of the otherwise applicable requirement. For example, to list on the Nasdaq Global Market the valuation (if not gleaned from a private placement market) will need to be at least $8 per share. Likewise, each of the liquidity calculations will need to exceed 200% of the regular listing requirement.
Furthermore, if Nasdaq determines that the valuation evidence required by IM 5405-1 and IM-5505-1 is not reliable, Nasdaq will require evidence, including a review of all facts and circumstances, that the various valuation and pricing requirements exceed 250% of the listing standards. The rule release reminds companies that Nasdaq has broad discretion over the listing process and may deny an application, even if the technical requirements are met, if it believes such denial is necessary to protect investors and the public interest. I suspect that Nasdaq will carefully review any applications for a direct listing.
Foreign Exchange Listings
Where a company is transferring from, or seeking to dual list on, Nasdaq from a foreign exchange where there is a broad, liquid market in the securities, Nasdaq will consider the value based on the recent trading price in the foreign market.